Q&A: A large foreign bequest could trigger U.S. taxes

Dear Liz: I have received an inheritance of $445,000 from a relative who died out of the country. Do I have to pay income tax on this money?

Answer: If you inherited from someone who was a U.S. citizen who lived abroad, then that person’s estate may be subject to U.S. estate taxes. The estate would have to be quite large, though. In 2017, estates worth less than $5.49 million per person were exempt from the tax. In 2018, the amount was raised to $11.18 million.

If you had paid any taxes on your inheritance to a foreign government, you could take a tax credit on your U.S. tax return for that amount.

Otherwise, you probably won’t owe any taxes. The federal government and most states don’t levy inheritance taxes on people who receive bequests. The exceptions are Iowa, Kentucky, Nebraska, Maryland, Pennsylvania and New Jersey, which do levy taxes on inheritances. All exempt spouses, and some exempt other immediate relatives.

Q&A: Here are some tips for getting more retirement money into accounts with tax advantages

Dear Liz: My wife and I are about 35. I’m self-employed and contribute to a SEP IRA. My wife contributes to a workplace retirement plan. We don’t qualify to contribute to Roth IRAs. In order to get more money into retirement accounts, would you recommend doing back-door Roth contributions? What else is there to do to get retirement money into accounts that will have a tax benefit now or later?

Answer: Roth IRAs don’t provide an upfront deduction, but withdrawals are tax-free in retirement. That makes them especially enticing to people who expect to be in the same or higher tax bracket in retirement — mostly higher-income people and good savers.

People who earn more than certain limits, however, are prohibited from contributing directly to a Roth IRA. For 2018, direct Roth contributions aren’t allowed for people whose modified adjusted gross incomes exceed $199,000 for married couples filing jointly or $135,000 for single filers.

Several years ago, however, Congress eliminated income limits on who was allowed to convert a regular IRA to a Roth IRA. That change created the back-door Roth strategy, in which a high-income taxpayer contributes to a regular IRA and then converts the money to a Roth.

The strategy works best for people who don’t already have a large IRA filled with pre-tax contributions and earnings. When you convert all or some of an IRA to a Roth, you have to pay a proportionate amount of income taxes on the conversion based on all of your IRA holdings. If you don’t have an existing IRA and don’t deduct the IRA contribution, you’ll owe little if any taxes on the conversion.

The IRS hasn’t specifically blessed or banned the back-door Roth strategy, so it remains somewhat controversial. Many investing and brokerage sites promote it. Some proponents, however, recommend letting several months pass between the contribution and the conversion. The idea is to avoid IRS scrutiny by making the transactions appear to be separate decisions rather than one clearly meant to get around the contribution limits.

If you want to stay out of gray areas and potentially contribute more cash to your retirement, consider setting up a solo 401(k). This version of the popular workplace plan is meant for self-employed business owners with no full-time employees other than themselves and their spouses. Plan participants under age 50 can contribute up to $18,500 a year. Those 50 and older can contribute up to $24,500. The plan can have a Roth and an after-tax contribution option in addition to a pre-tax option. In addition, the business can make a 25% annual profit-sharing contribution (or 20% if the business is a sole proprietorship or single member LLC). The combined maximum of participant and business contribution is $55,000 for those under 50 and $61,000 for those 50 and older.

If you’re able to contribute more than these amounts each year, consider a traditional defined-benefit pension. Those involve considerable set-up and ongoing costs, so consult a tax pro to see if it’s a good fit.

Q&A: Don’t get tripped up by invalid Roth IRA contributions

Dear Liz: A friend told me that when he takes out his required minimum distribution from his traditional IRA and pays the tax, he then puts the money in his Roth IRA. I believe since this was not earned income, this was wrong. Who’s right?

Answer: The money contributed to an IRA doesn’t have to be earnings, necessarily, but your friend or his spouse must have income earned from working to make an eligible contribution. Earned income includes wages, salary, tips, bonuses, professional fees or small business profits. Earned income does not include Social Security benefits, pension or annuity checks and distributions from retirement accounts.

Another restriction is that contributions can’t be greater than the amount of earned income. If your friend or his spouse earned $3,000 last year, that’s all he’d be allowed to contribute — not the $6,500 maximum allowed for people 50 and over.

The ability to contribute to a Roth begins to phase out when someone’s modified adjusted gross income exceeds certain amounts. In 2017, single filers’ ability to contribute phased out between $118,000 and $133,000. For married couples filing jointly, the phase out began at $186,000 and ended at $196,000.

The penalty for ineligible contributions is 6% of the ineligible amount. The penalty is owed each year the taxpayer allows the lapse without correcting the oversight. If your friend has been doing this for several years, the penalty will be pretty painful.

He could cross his fingers and hope the IRS doesn’t notice, but the error isn’t that hard for the agency to catch. The IRS would simply need to compare Form 5498, which IRA custodians issue to report contributions, to your friend’s income and the sources of that income to know whether he was eligible to put money in an IRA.

Q&A: Revocable living trusts don’t help with taxes

Dear Liz: Thanks for your recent column on setting up a living trust. This sounds like something that I should do, but I have a few questions. Would federal and state taxes be due on earnings on assets in the trust? Would these taxes due be paid out of earnings of the trust? Would I continue to pay taxes on my income from sources other than the trust?

Answer: Revocable living trusts are an estate-planning tool used to avoid probate, the court process that otherwise follows death. Unlike many other types of trusts, revocable living trusts don’t trigger special tax treatment. You’re still considered the owner of the assets, so you’ll continue reporting earnings and income on your individual tax return, as you previously did.

Revocable living trusts also don’t get special estate tax treatment. Revocable living trusts are designed to eliminate the potential costs and delays of probate, not of the estate tax system. Living trusts may include provisions meant to reduce estate taxes, such as language creating a bypass trust upon death, but those are the same kinds of provisions that can be included in wills.

Q&A: Cash gift to daughter shouldn’t trigger fine

Dear Liz: I gave my daughter $30,000 in 2015. I was fined $5,000. Why? I had not talked with another daughter, who does my taxes, so I was not aware that I could give only $14,000. If I had known, I could have given her the money over two years. Why wouldn’t they advise me as such?

Answer: It’s not clear whom you mean by “they,” but you need to have a chat with the daughter who does your taxes, because it’s extremely unlikely you were fined by the IRS for your gift.

In 2015, you wouldn’t owe gift taxes until you had given away more than $5 million in your lifetime above the $14,000-per-person annual limit. (That lifetime limit, by the way, has been raised to over $11 million, and the annual gift exclusion limit is now $15,000.)

If you had to pay an extra $5,000, it was for something else. Let’s hope the tax-preparing daughter didn’t decide to “fine” you for favoring your other child.

Q&A: Why failing to pay your taxes is a risky form of protest

Dear Liz: I write in earnest hope that you might consider giving advice to those wondering about withholding federal taxes as a form of protest over the enactment of the new tax bill. What are the possible legal ramifications of withholding federal taxes?

If one is willing to accept the possible consequences, how might one go about the nuts and bolts of not paying federal taxes, and are there any measures one might take to mitigate the legal consequences somewhat? For instance, if one spouse withholds taxes but the other pays, does filing separately at year’s end afford any layer of protection to the paying spouse?

Answer: Please find another way to protest.

The Internal Revenue Service has extraordinary powers to collect what it’s owed. The agency can seize your bank accounts, property and a portion of your income. People who willfully fail to pay their taxes can wind up in prison. Filing taxes separately may keep the paying spouse on the other side of iron bars, but it won’t prevent his or her life from being disrupted.

Our duty to pay taxes doesn’t rest on our approval of every single aspect of the tax code. If that were the case, few of us would pony up. Fortunately, in a representative democracy you have plenty of legal options to work for change. The same Constitution that gives Congress “the power to lay and collect taxes” also gives you the right to express your opinion, to assemble in peaceable protest and to vote for new lawmakers at the appropriate times.

If you want to work for change, do so in ways that actually have a chance at success, rather than one that will succeed only in making your life worse.

Q&A: How to sort out the taxes when you sell your house

Dear Liz: I am trying to understand the capital gains tax exemption as it applies to the sale of a house. If I have no mortgage and I sell my house before I have lived in it for two of the previous five years that are now required for the exemption, is it based on the total selling price of the house or on the amount over what I paid for it? And what is the tax rate based on?

Answer: The home sale exemption can shelter from taxes up to $250,000 per owner ($500,000 for a couple) of capital gains from a home sale. If you don’t live in the home for at least two of the previous five years, you typically can’t use the exemption unless the sale was because of a change in employment, health problems that require you to move or an unforeseen circumstance that forced the sale.

The rules on these exceptions can get pretty tricky, so you’d need to discuss your situation with a tax pro. If you qualify, the amount of the exemption usually would be proportionate to the percentage of the two years that you actually lived in the home. If you sold after one year, for example, you might exempt up to $125,000 per owner.

Whether you have a mortgage does not affect the capital gains calculation. What matters is the difference between the price you get when you sell the house and the price you paid when you bought it.

From the sale price, you get to subtract any selling costs such as real estate commissions. From the purchase price, you can add in certain costs, such as home improvement expenses. What results after these adjustments is your capital gain for tax purposes.

If you have capital gains in excess of the exemption, you would pay long-term capital gains rates on that profit. Long-term capital gains are typically taxed at a 15% federal rate, although the highest-income taxpayers (those in the 39.6% bracket) may pay 20% and the lowest-income taxpayers (those in the 10% and 15% brackets, including taxable capital gains) pay a 0% rate.

States typically have additional taxes.

Q&A: Government financial help after disaster may come as a loan

Dear Liz: With all the recent hurricanes and other natural disasters, people are being helped by the Federal Emergency Management Agency with money for rentals or home replacements. What repayment does the government expect? Are there taxes owed by the recipients of that money?

Answer: FEMA grants aren’t taxable, but they’re typically not enough to replace a home. FEMA may provide up to $33,000, but the typical grant is much smaller — in the $3,000-to-$8,000 range, according to recent data from the agency.

Most financial assistance after a disaster comes in the form of low-interest loans to renters and homeowners, offered through the Small Business Administration. Recipients are expected to repay those loans.

Q&A: To give or not to give can be a taxing question

Dear Liz: A good friend who is childless wishes to give his property to my daughter before his death. He has been an informal uncle for the whole 50 years of my daughter’s life, and we are, in effect, his family. However, I am concerned that the gift tax may be more than he bargained for. He is not tax-aware, and earns very little, so his tax knowledge is skimpy. He owns his property outright, however.

I know that someone can give as much as $14,000 without having to file a gift tax return and that there is a “’lifetime exemption” of more than $5 million. If his property is worth, say, $500,000, can he be tax free on a gift of that magnitude by, in effect, using his lifetime exemption?

Answer: Essentially, yes, but he may be creating a tax problem for your daughter.

Gift taxes are not something that most people need to worry about. At most, a gift worth more than $14,000 per recipient would require the giver to file a gift tax return. Gift taxes wouldn’t be owed until the amount given away in excess of that annual exemption limit exceeds the lifetime exemption limit of $5.49 million.

Capital gains taxes are another matter and should always be considered before making gifts. Here’s why.

Your friend has what’s known as a “tax basis” in this property. If he sold it, he typically would owe capital gains taxes on the difference between that basis — usually the purchase price plus the cost of any improvements — and the sale price, minus any selling costs. If he has owned the property a long time and it has appreciated significantly, that could be a big tax bill.

If he gives the property to your daughter while he’s alive, she would receive his tax basis as well. If she inherited the property instead, the tax basis would be updated to the property’s value at the time of your friend’s death. No capital gains taxes would be owed on the appreciation that took place during his lifetime.

There’s something else to consider. If your friend doesn’t make much money, he may not have the savings or insurance he would need to pay for long-term care. The property could be something he could sell or mortgage to cover those costs.

If he gives the property away, he could create problems for himself if he has no other resources. Medicaid is a government program that typically pays such costs for the indigent, but there’s a “look back” period that could delay his eligibility for coverage. The look-back rules impose a penalty for gifts or asset transfers made in the previous five years. He should consult an elder-law attorney before making such a move.

Q&A: Obsessing over taxes is foolish

Dear Liz: Most of your articles are from people who have not yet retired. I am retired and always expected to be making less money now than when I was working. But the opposite has happened. I am making almost twice as much and I have a lot of money in stocks, which have increased dramatically. I want to travel and use that money but anything I sell will be taxed at the 25% rate. Any ideas how to get my money out and be able to use it?

Answer: Sure. Place a sell order, set aside 25% for taxes and enjoy your life while you still have a life to enjoy. If you’d like to reduce your yearly tax bill, consider bumping up your charitable contributions to help those who aren’t so fortunate.

Paying taxes is not fun, but obsessing about ways to avoid them or letting them dictate your decisions is foolish. You’ll still be far better off than you expected to be after you pay Uncle Sam, and you’ll have the cash to do what you want. So do it.